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Why We're Increasing Halliburton's Moat to Narrow

We think Halliburton represents an attractive opportunity at today's levels.

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We think  Halliburton (HAL) represents a fairly attractive opportunity at today's levels, as it is one of the cheapest companies in our oil services universe. The company has performed extremely well during the 2008-09 downturn and subsequent recovery, and we think its 2011 prospects look bright, as its end-stage markets continue to improve. In addition, we believe the recent industry consolidation as well as the company's drilling solutions has earned it a narrow moat. More quantitative metrics also support Halliburton's moat, as over the past few years the firm has delivered returns on invested capital well in excess of its cost of capital, and we expect this value creation to persist going forward. In this article, we share the detailed reasoning behind our decision to increase Halliburton's moat to narrow.

Industry Consolidation
Historically, we've been reluctant to award moats to the services players outside of  Schlumberger (SLB), as sustainable pricing power has been elusive, due to the industry's volatility. That said, with the industry consolidation that has taken place over the past year with the Schlumberger/Smith and  Baker Hughes (BHI)/BJ Services deals, we think the industry's long-term pricing power has strengthened. Halliburton has also used the 2008-09 downturn to take out many smaller competitors by setting prices below their cash break-even costs. The aggressive moves during the downturn positioned Halliburton to turn in industry-leading performance in North America as the market recovered in 2010.

The industry rebound was driven by unconventional activity, which we think also favors larger services players such as Halliburton. The services intensity (services revenue per rig) for some of the liquids-rich shale plays has doubled in the past two years, and has increased about 10% annually for the past decade. Now, about $80 million in services equipment needs to be on site for some wells, versus $20 million in equipment two years ago. The huge need for equipment and people means that smaller players do not have the people, equipment, or capital needed to keep up with the larger players. As the services equipment broke down in the shale plays during the downturn, Halliburton took advantage of its strong financial position by investing in new replacement capacity, and stole huge swaths of market share from its smaller peers.

The disappearance of the small industry players has caused the oil and gas companies' bargaining power to clearly diminish over the past two years.  Petrohawk (HK) has tried to sponsor smaller services players by giving them work even when it was cheaper to go with a larger services provider, but that has not worked out very well. After  Shell (RDS.A) bought out some shale acreage, they promptly fired all of the services venders and consolidated their work with Schlumberger and Halliburton. Unsurprisingly, Shell and other oil and gas companies are considering long-term contracts for services work. The advantage for the oil and gas companies is that they know they will have predictable and skilled services providers helping them develop their valuable acreage. Of course, the services industry has stated they are opposed to long-term services contracts, which makes a lot of sense in a strong services pricing environment. Finally, the shift toward a "manufacturing model" by the oil and gas companies for unconventional drilling has actually played to some extent into the services industry's hands, as it has diminished the risk of a new technology or drilling approach upending the industry's offerings.

Halliburton's Optimized Drilling Solution
For more than a decade, Halliburton has been working on integrating its drilling services to fully optimize drilling performance while lowering costs. Halliburton began by placing its drilling engineering applications under one roof, which includes fluids, bits, and directional drilling. Over time, the firm has integrated its services into a single solution, which means that a customer can potentially obtain substantially greater well performance and reduced levels of non-productive time by standardizing on Halliburton's services rather than mixing services from multiple services providers. We believe this type of offering will be quite difficult for traditional competitors to duplicate, and impossible for smaller services providers.

We believe the integrated aspect of the offering helps retain customers--if the customer tries to bring in an outside and cheaper provider, the additional savings will likely be more than offset by the degraded well performance. The optimization approach changes the services offering from a collection of individual products that are each exposed to significant price competition to a single solution that requires a peer to offer a fully-optimized and integrated product portfolio, which is much harder to do. At its 2010 Analyst Day, Halliburton indicated that 50% of the wells it drilled for a certain customer in the North Sea were in the top quartile of all wells drilled in that basin for the year, which saved the customer on average between $2 million and $10 million per well.

Savings such as the above example are commonly cited by services providers as evidence of the value of the technology and expertise they bring to the table. We believe the savings are real for customers, but it is hard to build a sustainable competitive advantage over peers in this highly-competitive industry, as we think peers can typically duplicate savings derived off a single product or product line fairly quickly. The value in Halliburton's packaged approach is that it doesn't just bolt together the various technologies, but it uses proprietary work flows and input from different drilling disciplines to build a compelling solution. We estimate Halliburton's packaged offerings now make up around 40% of its revenue, with most of that success coming from North America.

In our view, Halliburton's competitors are struggling to catch up. Our estimates place packaged revenue for Baker Hughes at around 5%-10% of its business. We think Schlumberger paid the huge stock price premium for Smith's drill bit and fluids assets earlier this year largely due to the compelling value proposition from offering a fully-integrated drillstring solution. We suspect part of the reason why Schlumberger realized the strategic value of this approach so late is that it has focused more on international markets rather than North America, which is where packaged services caught on first. The value proposition also likely explains  Patterson's (PTEN) and  Nabors' (NBR) acquisitions of pressure-pumping assets earlier this year, but we note there are virtually no synergies between rigs and pressure-pumping assets, so it will be hard for the drillers to compete with Halliburton's optimized approach.

Halliburton estimates that around 60% of its well completions by the end of 2011 will be using fully-integrated offerings, and we think its peers' approaches are not quite as fully developed. We think Schlumberger is closest to having a comparable solution, but Baker Hughes and Weatherford still have a lot of work to do. In addition, about 50% of Halliburton's North American revenue is made up of just 16 customers, which implies that some of the largest services spenders in the U.S. have bought heavily into Halliburton's optimized drilling solution. We believe Halliburton now has a group of very sticky and high-spending customers, which will benefit the firm going forward.

Stephen Ellis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.